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Central Bank Intervention and Exchange Rates: the Case of Sweden

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Central Bank Intervention and Exchange Rates: the Case of Sweden A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Aguilar, Javiera; Nydahl, Stefan Working Paper Central bank intervention and exchange rates: The case of Sweden Sveriges Riksbank Working Paper Series, No. 54 Provided in Cooperation with: Central Bank of Sweden, Stockholm Suggested Citation: Aguilar, Javiera; Nydahl, Stefan (1998) : Central bank intervention and exchange rates: The case of Sweden, Sveriges Riksbank Working Paper Series, No. 54, Sveriges Riksbank, Stockholm This Version is available at: http://hdl.handle.net/10419/83039 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu &HQWUDO%DQN,QWHUYHQWLRQDQG([FKDQJH5DWHV7KH&DVHRI 6ZHGHQ* Javiera Aguilara and Stefan Nydahlb This version: June 14, 1998 $EVWUDFW This paper examines the effect of the Riksbank’s currency market interventions on the level and the volatility of the USD/SEK and DEM/SEK exchange rates between 1993 and 1996. To model volatility both GARCH models and implied volatilities from currency options are used. Some support is found for the idea that interventions affect the exchange rate level during certain sub periods but overall the results are weak. Furthermore, in line with the findings for other countries, little empirical support is found for the hypothesis that central bank intervention systematically decreases exchange rate volatility. ;IEVIQSWXKVEXIJYPXS4IXIV)RKPYRH&N¸VR,ERWWSR,ERW0MRHFIVK4IXIV7IPPMRERHIWTIGMEPP]%RHIVW :VIHMRJSVGSQQIRXW'SQQIRXWJVSQWIQMREVTEVXMGMTERXWEX7ZIVMKIW6MOWFERO[IVIEPWSLIPTJYPMR MQTVSZMRKXLITETIV1SWX[SVOSRXLMWTETIV[EWHSRI[LMPIXLIWIGSRHEYXLSVLIPHERMRXIVRWLMTEXXLI 6MOWFERO,IXLEROWXLI6MOWFEROJSVJMRERGMEPWYTTSVXHYVMRKXLMWTIVMSH8LIZMI[WI\TVIWWIHLIVIEVI XLSWISJXLIEYXLSVWERHHSRSXRIGIWWEVMP]VIJPIGXXLSWISJ7ZIVMKIW6MOWFERO E1SRIXEV]ERH)\GLERKI6EXI4SPMG](ITEVXQIRX7ZIVMKIW6MOWFERO F(ITEVXQIRXSJ)GSRSQMGW9TTWEPE9RMZIVWMX] ,QWURGXFWLRQ During the last decades economists have changed their views regarding the effects of foreign exchange market interventions on the exchange rate. Under the Bretton Woods system of fixed exchange rates, interventions were used frequently to maintain the exchange rate within prescribed margins. After the breakdown of the Bretton Woods system in 1973 the magnitude of interventions initially increased. In the early 1980s, the Reagan administration viewed interventions as both costly and inefficient and adopted more of a laissez-faire approach towards foreign-exchange markets. European central banks however continued to intervene to keep their currencies within the bands prescribed by the Exchange Rate Mechanism (ERM). The U.S. skepticism against interventions was partly based on the fact that research in the late 1970s seemed to show that exchange markets are efficient. Most empirical studies failed to find effects of interventions on the exchange rate. However even during this period some economists stressed that foreign exchange rate markets do not work as commodity markets. They claimed that in exchange rate markets without interventions or restrictions on asset holdings equilibrium exchange rates will not be determined (Wallace, 1978). During the first half of the 1980s the dollar appreciated by approximately 50 percent in nominal terms. When the Congress threatened to adopt severe protectionistic measures the Federal Reserve began to intervene, but this time with the help from the G5 countries. Following the perceived success of these interventions economists began to reassess the effectiveness of interventions. A majority of the new studies produced concluded, in line with the earlier results, that interventions effects on the exchange rate are minor at most. Still, most central banks continue to be active in the foreign exchange market. One explanation could be that countries with floating exchange rates usually try to decrease exchange rate volatility rather than move the level of the exchange rate. Indeed in the IMF Executive Board’s 1977 guiding principles for intervention policy it is explicitly stated that countries should use interventions to decrease volatility in exchange rates (Dominguez, 1996). A major part of the studies in this area of research is concerned with the effects of interventions on the DEM/USD and JPY/USD exchange rates. Very little has been done for other currencies. As pointed by Edison (1993) one main reason for the lack of empirical studies for other countries is that it is hard to get access to good data for interventions. In this paper we study the effect of sterilized interventions on the Swedish krona from 1993 to 1996 using unique daily data on actual interventions made by the Riksbank. After a period of severe speculative attacks against the Swedish krona the Riksbank let the krona start to float in November 1992. This was the first time since the thirties that Sweden experienced a floating exchange rate regime. It is of interest to explore the effects of interventions conducted under a floating exchange rate regime in a small open economy. The paper is organized as follows: Section 2 describes theory and different channels through which interventions could affect exchange rates. Section 3 presents empirical results. We test the effects of interventions both on the exchange rate level and on the exchange rate volatility. Section 4 concludes. 7KHRU\RIVWHULOL]HGLQWHUYHQWLRQV The Riksbank has during the period investigated in this paper neutralized the money stock effect of its interventions, i.e. used so called sterilized interventions. It is generally accepted among economists that nonsterilized interventions affect exchange rates in the same way domestic open- market operations. Nonsterilized interventions change the stock of base money and thus monetary aggregates and interest rates. The effects of sterilized interventions are however more controversial because the monetary base is not altered; the central bank make an offsetting transaction through an open market purchase or sale of domestic government securities or by granting more or less credit to the commercial banks. Thus a sterilized intervention simply alters the currency composition of domestic and foreign assets of the private sector portfolio investments but leaves the money supply unchanged. It is common practice among central banks to neutralize the money market effect of interventions in order to let exchange rate policy not interfere with domestic monetary policy. There are many theories on the scope of foreign exchange market intervention. For a comprehensive survey we refer the interested to Almekinders (1995, Ch.2). Here we take the asset market view of exchange rates as a simple formal framework to discuss the different channels through which sterilized intervention may affect the exchange rate. Following the standard asset pricing model approach to exchange rates the following process is considered for the exchange rate, VI=+α (VΩ − V WW[] WWWW()+1 (1) V I ( where W is the (log) exchange rate at time t, W represents the current period "fundamentals", W is the expectations operator and ΩW is the information set in period t. Hence the exchange rate in period t is determined by the fundamentals in period t and the expected capital gain, (VΩ − V WW()+1 W W , of holding the currency until the next period. Equation (1) can be rewritten as, 1 α VI(V= + ()Ω (2) WWWWW11+ α + α +1 i.e. a stochastic difference equation. The general solution to equation (2) is given by a set of solutions that each may be expressed as, * VVEWWW=+ (3) + α * 1 where V is the fundamental value and E is a rational bubble satisfying, (E[]Ω = E. W W WW+1 α W * VW is the unique solution to (2) under the assumption of no bubbles. To see this we solve equation (2) recursively , M 7 + 1 7 α α 1 V(I(V= ∑ ()ΩΩ+ () W WWMW+ WW7++1 W (4) 11++α M α 1+ α α 7 +1 Under the assumption that ( ()V Ω = 0 , the unique solution to (2) is, lim W W +7 +1 W 7 →∞ 1+α M 1 ∞ α V* = ∑ ( ()I Ω (5) W +α +α W W+ M W 1 M=0 1 Hence the solution for VWcan be written as, M 1 ∞ α α V = ∑ ( ()I Ω + ([]E Ω (6) W +α +α W W+ M W +α W+1 W 1 M=0 1 1 where the exchange rate is divided into two terms, the expected present value of future fundamentals and a bubble. Note the implication of the second term; for a bubble to survive it must reflect the expectation that it will continue to expand in the following period. We use the expression in (6) as a starting point to discuss how interventions can affect the exchange rate trough different
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